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IAI Actuarial Core Principles · Business Economics · Role of money and interest rates in the economy

The Reserve Bank of India increases the money supply while money demand is unchanged and the economy is not in a liquidity trap. According to liquidity preference theory, what happens in the money market?

The equilibrium interest rate falls. With demand unchanged, a larger money supply can only be held willingly if the opportunity cost of holding money falls, so the rate declines and bond prices rise. Money demand itself does not shift.

  1. AThe equilibrium interest rate rises because there is more money to lend
  2. BThe equilibrium interest rate falls, since people must be induced to hold the larger money stock by a lower opportunity costCorrect
  3. CThe money demand curve shifts left
  4. DBond prices fall as interest rates fall
  5. The equilibrium interest rate is unchanged because supply is vertical

Explanation

The supply curve shifts right while demand is fixed. For people to willingly hold the extra money, the opportunity cost of holding it, the interest rate, must fall. Bond prices rise when rates fall, so the bond-price option is wrong, and the vertical supply curve simply shifts rather than leaving the rate unchanged.

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